Last week, Whole Foods (NASDAQ:WFM) showed it hasn’t lost its growth magic. In the fiscal fourth quarter, WFM’s revenues improved by 13% year-over-year to $3.03 billion on same-store sales that were 6.9% better, and earnings increased 19% to 76 cents per share.
That prompted investors to bid up WFM shares to an all-time high of $103.72, sending its market cap to about $19 billion. The company even announced a 2-for-1 stock split.
WFM has certainly been a long-term winner for investors. During the past five years, the average annual return was an impressive 26%. But should you buy Whole Foods now … or has it become too expensive? We explore the pros and cons to find out.
Pros
Premium Brand: WFM is the pioneer of the natural and organic retail market. Since its start in 1980, the company has continued to stay true to its vision and build strong customer loyalty. A typical WFM location has a wide assortment of differentiated foods, with an average of 21,000 SKUs. Of course, WFM is committed to buying from local producers who meet high quality standards, but the company also looks at other factors. Its consideration for environmental practices, humane treatment of animals and sustainability has been important in setting the company apart from the growing competition.
Secular Trends: Consumers have been focusing more on health and wellness, which has driven growth in the natural and organic food segment. Between 1997 to 2011, the annual improvement was about 12%, and the Nutrition Business Journal forecasts a growth rate of 10% during the next seven years or so. It expects the vitamin and supplement market to grow at about 7% during this period as well. In light of all this, WFM has invested heavily in building new stores. Last year, the company launched 85 stores (for a total 349), and has 89 more down the pike.
Financials: Financials are definitely healthy, with about $1.3 billion in the bank. Plus, the company is a big cash generator, producing $590 million in cash flow last year, up from $517 in 2011. A key to WFM’s success has been achieving substantial operating margins, which currently sit at 6.71%. That’s roughly twice as high as other players in the general grocery market, like Safeway (NYSE:SWY) and Kroger (NYSE:KR).
Cons
Alternatives: Over the years, WFM’s success has attracted lots of competition, and some of the emerging players in the space have become formidable. These include Natural Grocers by Vitamin Cottage (NYSE:NGVC) and The Fresh Market (NASDAQ:TFM). And another competitor, Sprouts, has recently filed to go public. But even traditional grocers are moving more aggressively into the natural and organic food market. They could easily use their enormous resources, marketing and massive footprints to take away market share.
New Strategy: Earlier in the year, WFM spooked investors because management said it would focus more on discounting and promotions. There were several reasons provided, such as reducing spoilage, increasing basket size and boosting store traffic. But perhaps the real reason is that WFM believes it cannot continue to charge such high prices. New industries will generally see erosion in margins, and consumers eventually expect prices to get more reasonable over time. Also, besides having to deal with growing competition, WFM might have a tough time finding new customers with sufficient purchasing power amid a sluggishly improving economy.
Valuation: The company currently trades at 29 times forward earnings, so even a slight miss in earnings could leave the stock vulnerable — especially considering the meager 0.8% dividend yield is a poor counterweight to rougher trading waters.
Verdict
True, Whole Foods does face tough competition, but that’s to be expected of any company with a strong growth rate.
Nonetheless, WFM still believes it has ample room to expand in the U.S., and is targeting 1,000 stores. And again, Whole Foods is the leading brand name in is industry, which is a great ace to hold. In light of such factors, it is natural for a company to trade at a hefty premium.
So should you buy Whole Foods? Yes — so long as it keeps executing, WFM still has potential to reward shareholders with outsized returns.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.
